The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Monday, August 26, 2013

Why should ECB's bank asset quality review be believed?

Given Mario Draghi's commitment to do whatever it takes, why should the ECB's review of the asset quality at the EU banks be remotely believable?

Please recall, this is not the first time a governmental entity has overseen an asset quality review. Previously, these reviews were done in Ireland, Greece, Cyprus, Portugal and Spain.

The result of these reviews was predictable. The banks took additional reserves for potential losses and the governments declared their balance sheets had been cleaned up.

Of course, the banks were not required to disclose their current asset, liability and off-balance sheet exposure details so that market participants could confirm that all their losses had been recognized.

A few savvy market participants recognized that this lack of transparency was the equivalent of waving a giant red flag and announcing that the banks were still hiding losses on and off their balance sheet.

These market participants' insight have always been confirmed as shortly after the asset reviews it would be shown that there were in fact many more losses hiding on and off the bank balance sheets.

This pattern has held true whether the asset review was carried out by the government itself or using an "independent" third party (accounting firm or BlackRock).

This pattern has also held true when the asset quality review has been combined with stress tests.

So your humble blogger's question stands: why in the absence of transparency would anyone believe the results of the ECB's asset quality review?

One of the downsides of the ECB running an asset quality review without requiring the banks to provide transparency is that ECB puts itself in the position of now having to accept as collateral any of the assets it reviewed and didn't require loss recognition on.

Within a matter of weeks, assuming legislative go-ahead, the ECB is expected to establish its new “single supervisory mechanism”, hiring the 1,000 staff it will need to police the banks, and making its mark with a tough root-and-branch Asset Quality Review (AQR) to determine how truthful banks are being about the loans on their balance sheets....

Properly done, the exercise could quickly establish the ECB as a tough regulator and help restore investor faith in Europe’s lenders. A succession of botched stress tests over recent years and laggardly recapitalisation of troubled lenders have deterred investors from backing the sector.

A credible AQR, followed immediately by a stress test to show how balance sheets would stand up to further trouble, would, it is hoped, convince the world that Europe’s lenders are as resilient as US banks okayed by the Federal Reserve’s annual Comprehensive Capital Analysis and Review (CCAR).

No one thinks the US banks are okay. Everyone knows that as a result of the stress tests the US on an annual basis renews the vow made by then US Treasury Secretary Tim Geithner when he pledged the full faith and credit of the US to keep the banks solvent.

All of which explains the flurry of preparations.

Italy’s Intesa SanPaolo has been the most upfront about its desire to be ready for the ECB process. This month the bank revealed a “conservative” 30 per cent increase in the amount it has set aside to cover bad loans, undertaken explicitly “in the light of the [ECB’s] asset quality review”....

In the absence of exposure detail transparency, how would anyone know if a 30 percent increase in the amount set aside to cover bad loans is "conservative" or not?

Based on the history of Ireland, Greece,.... it is a fairly safe bet that this additional 30% will not be shown to be conservative and that much more in the way of losses will materialize.

The ECB exercise is set to implement new pan-European definitions of non-performing loans, standardising an NPL as anything that is 90 days past due, and also forcing banks to categorise all exposures to a single borrower as non-performing, even if only one of a number of loans is actually in default....

In the presence of regulatory forbearance which allows banks to engage in 'extend and pretend' and turn non-performing loans into 'zombie' loans, it is nice to have a standard, but the regulators have already undercut it.

Autonomous, an independent research house, predicts the changed definitions could increase problem loans by an average of 40 per cent – forcing weaker banks to raise fresh capital. Lenders in Germany, Austria and France could face the biggest shocks in the AQR....

I guess Autonomous doesn't see the 30% increase in loan loss reserves as conservative.

But a litany of ifs and buts still hangs over the whole process. Most immediately, it is still uncertain whether the EU will deliver the legal go-ahead to empower the ECB next month.

More fundamentally, there is still disagreement about how to deal with a bank if it fails to plug a capital shortfall under its own steam.

Here, too, Europe must learn from the US, where the government’s Tarp scheme injected capital as necessary back in 2009. For the ECB exercise to work, the sovereign-focused European Stability Mechanism must become a bank bail-out vehicle of last resort.

The issue for a bank fixing its book capital shortfall is can it generate earnings after all the losses have been realized.

If a bank can generate earnings after taking the losses on its dud exposures, it can recapitalize itself over time by simply retaining earnings.

If a bank cannot generate earnings after taking the losses on its dud exposures, it should be resolved.

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.